Commentary: Is today's stock market like fall 1998 or late 1970s?

The newsletter editors I monitor are all over the map in arguing about which period of stock-market history is the closest analog to today's market. Not surprisingly, they are issuing diametrically opposed forecasts on the basis of their chosen positions.

Many of the newsletter editors I monitor see all the hallmarks of a 1970s-like stagflation just over the horizon. During the latter part of that decade the Federal Reserve inflated the U.S. economy to try to avoid a recession. But, far from robust economic growth, the result was anemic growth at best and soaring inflation. Gold bullion
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skyrocketed, while stocks on the whole proved disappointing.

In fact, over the four years from the beginning of 1976 through the end of 1979, the Dow Jones Industrial Average
DJIA, -1.24%
fell from 852 to 839. And note carefully that this four-year decline was in nominal terms; the dollar itself lost more than a quarter of its purchasing power during that period.

Such a parallel is a scary prospect indeed, and helps to explain why many equity advisers remain largely or completely in cash right now, despite the Dow being just 1.3% from an all-time high. Their gloom is evident in the average recommended equity exposure among the short-term market-timing newsletters tracked by the Hulbert Financial Digest. This average is today some 20 percentage points lower than where it in mid July as the stock market was mounting its assault on the 14,000 level.

Contrarians, of course, are suspicious of any developing consensus, and therefore are beginning to doubt that the latter years of the 1970s are as helpful a historical parallel after all.

Richard Band, editor of the Profitable Investing newsletter, is one of the most consistently contrarian editors I monitor. For an historical analogy to today's market, Band looks no further back to the fall of 1998, some nine years ago. That was when the global currency markets went haywire, stock markets melted down, especially in Asia (remember the term "Asian Contagion"?), and Long Term Capital Management went bankrupt and alerted the world, many for the first time, to the markets' vulnerability to the unwinding of hedge-fund leverage.

This past week, when reviewing the Federal Reserve's cutting of both the federal funds rate and the discount rate, Band wrote: "Last month, the Fed slashed the discount rate by half a point and even urged healthy institutions to take advantage of the concession. Now Ben's crew has dropped the discount rate again. It's as if Bernanke is saying to the financial markets: 'I've got a fire hose full of cash, and I'm going to keep shooting it until this conflagration (the credit panic) is thoroughly doused. Got the message?' "

"I don't know about other investors, but the message hasn't been lost on me," Band continued. "This latest Fed move, and the market reaction to it, are almost a carbon copy of what happened at the end of the 1998 Asia/Russia/Long-Term Capital Management crisis. Back then, Fed funds dropped from 5.5% to 4.75%. Then as now, the stock market exploded with a daily gain (October 9, 1998) very much like today's. And the S&P 500
SPX, -1.54%
went on to skyrocket 39% over the next 12 months."

Band hastens to add that he is not predicting an exact repeat of the stock market's impressive return over that the 12-month period. "Looking out a year, however, I think a 20%-25% rise in the blue chip indexes is well within the realm of possibility," he writes.

The Hulbert Financial Digest's tracking of Band's newsletter suggests we pay attention to his argument that it is 1998, not the late 1970s, that is the closest analog to today's stock market. The HFD has been calculating his newsletter's return since the beginning 1991, almost 17 years ago. Since then, according to the HFD, his model portfolios have produced an average return of 9.3% annualized.

Though that is below the 11.9% annualized return for the Dow Jones Wilshire 5000 index
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over this same period, Band's portfolios on average were 35% less risky than the overall stock market. On a risk-adjusted basis, Band's portfolios come out ahead of the stock market itself.

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